Optimal Monetary Interventions in Credit Markets

Abstract

In an environment based on Lagos and Wright (2005) but with two rounds of pairwise meetings, we introduce imperfect monitoring that resembles operations of unsecured loans. We characterize the set of implementable allocations satisfying individual rationality and pairwise core in bilateral meetings. We introduce a class of expansionary monetary policies that use the seignorage revenue to purchase privately issued debts. We show that under the optimal trading mechanism, both money and debt circulate in the economy and the optimal inflation rate is positive, except for very high discount factors under which money alone achieves the firstbest. Our model captures the view that unconventional monetary policy encourages lending while it may create inflation.